What is a Backup Line
A backup line is a line of credit (LOC) that protects the company's investors if the company defaults on its commercial paper. Commercial paper is mostly a promissory note that companies issue instead of issuing bonds or stocks.
These tend to be short-term securities that mature in less than a year. Most are sold below par, mature in about a month and are redeemed for their face value amount.
BREAKING DOWN Backup Line
The is no backing collateral for commercial paper. To protect investors from default the company can pay a fee to a bank in exchange for a backup line. The backup line will be used to pay off any commercial papers if the company defaults.
Backup lines can be arranged to cover either a portion or all of the commercial paper issued by a company. In general, only companies with excellent credit issue commercial paper. This company quality means that releasing a backup line poses a relatively low risk for banks. Any company needing one is likely to be reputable and with a robust strategic plan to pay off all commercial paper within a fixed (and short) timeframe.
How a Backup Line Works
A company may require a backup line when it plans a significant expansion. For example, a technology manufacturer may want to expand by purchasing a new factory building. The company will issue $1 million in commercial paper to buy the property. Investors are willing to buy the business paper because they have faith in the company and its excellent credit.
However, even with the company’s excellent history and credit rating, there’s always a chance that the company could default on its promise to pay back the $1 million in commercial paper. Roadblocks include a competitor overtaking the market with new technology, a natural disaster, or a sudden change in the labor market. Any of these factors and others could render one of the company’s factories inoperable. If something like this happens, the company will have purchased a backup line.
When the company decided to issue the commercial paper, it approached a bank and described the amount of commercial paper desired, and the strategy and the timeline for paying it off. Looking at the company’s credit and policy the bank can then determined how much of a line of credit it would guarantee the company, and at what cost. The company will pay a fee, which acts as an insurance policy on the commercial papers. If the company cannot pay back the $1 million, the bank will reimburse the remaining investors for what they are owed.